What’s the difference between second mortgage types?

Your home provides shelter and stability, but it can also be a financial tool.

If you own your home, you know it provides shelter and stability. But you might not have considered that your house has built up financial value, which you can tap into to meet other goals.

For many Americans, their home is their most valuable asset. As such, it can be a useful financial tool.

Equity is the difference between what your home would be worth in a sale and what you owe on your mortgage. As you make payments toward your mortgage principal over time, you increase your equity.

There are two primary ways to tap into your home equity: a home equity loan (HELOAN) and a home equity line of credit (HELOC). HELOANs and HELOCs are sometimes referred to as second mortgages. Because your home is used as collateral, they tend to have lower interest rates than personal loans or credit cards.

“We see a lot of people doing home improvements and renovations, such as an addition or a pool, but we also see people take out a second mortgage for debt consolidation, to buy land or assist with college expenses,” says DJ Coomer, Branch Manager at Regions Bank in Nashville, Tennessee.

Each home equity loan or line of credit type has its own terms and requirements, so it’s helpful to understand the differences.

Home Equity Loan

A home equity loan is a one-time transaction with a lender. The amount you can borrow depends on your income, credit situation, your home’s equity and how much debt is currently secured by your home. You receive the money in one lump-sum payment, and you can’t take out more funds without getting another loan.

Home equity loans have a fixed interest rate, which means borrowers will pay the same interest rate over the term of the loan. This makes the monthly payments consistent over time.

“If you’re on a specific budget and know the amount you need, it may be more advantageous to use a home equity loan,” Coomer says. In a rising-rate environment some customers may want to lock in the lower rate. “It’s beneficial for those who are very rate conscious and would rather stick to their budget,” says Coomer.

Home Equity Line of Credit

A home equity line of credit is a revolving credit line that you can borrow against as needed, up to your credit limit, Coomer says. At Regions, you can access the line through online banking transfers, advances inside the branch and convenient access checks, and with the EssentiaLine Visa® card (excluding Texas). You have a maximum amount that you can borrow and you only have to repay what you actually take out, plus any interest or fees.

“If the homeowner is taking on a lengthy project, the HELOC may be better,” Coomer says. “Unless you use it, you’re not paying anything on it.” The HELOC is going to provide you much more flexibility while giving you the same benefit of the home equity loan with our loan-in-a-line option, Coomer says.

You might consider a HELOC if you expect to have expenses of different amounts spread over a period of time. For example, if you know that you need to cover upcoming college expenses or medical bills, but you don’t know the exact costs, a HELOC could help you meet those needs. This way, you only pay interest on the amounts you actually need to borrow, rather than the full amount you are approved to borrow.

Unlike home equity loans, HELOCs typically have an adjustable interest rate, which means the rate could change over time. The rate is usually tied to a national index rate and can decrease or increase. That could change the amount of your payments to your lender, even if you don’t withdraw any more money. It’s important to review the repayment terms of your HELOC, as your mandatory payments could fluctuate based on the terms.

A HELOC may have a set number of years, called a draw period, during which you can borrow. You may be able to renew your credit line when the draw period ends. The repayment terms can be different during and after the draw period. Talk with your banker about your specific needs, and review the terms carefully to make sure they meet your needs and expectations.

Considerations When Borrowing Against Your Home

The interest paid on home equity loans and lines of credit may be tax deductible up to a certain amount. Consult a tax advisor to see if you qualify for the deduction.

With both a home equity loan and a HELOC, your home is the security your lender can leverage to ensure repayment of the loan. If you become unable to repay what you borrowed, your lender could foreclose the mortgage and sell your home to cover the debt. That means it’s important to understand the terms, and to make sure it fits your budget and overall financial plan.

Under the right circumstances, a second mortgage can help you cover important expenses that would be difficult to pay for upfront, and then repay the debt over a longer period of time. A home equity loan or home equity line of credit can be a valuable tool to help you reach your financial goals.